Environmental policy and macroeconomic dynamics in a new Keynesian model

• In a New Keynesian model we study the behavior of an economy under different environmental policy regimes.
• A cap-and-trade policy tends to dampen macroeconomic fluctuations.
• Price stickiness is found to affect the performance of the chosen environmental policy regime.
• The optimal environmental policy response to shocks depends on price stickiness and on the monetary-policy conduct.

This paper studies the dynamic behavior of an economy under different environmental policy regimes in a New Keynesian model with nominal and real uncertainty. We find the following results: (i) an emissions cap policy is likely to dampen macroeconomic fluctuations; (ii) staggered price adjustment alters significantly the performance of the environmental policy regime put in place; (iii) the optimal environmental policy response to shocks is strongly influenced by the degree to which prices adjust and by the monetary policy reaction.